1.

Foreign exchange markets structure, market making, geographical extent, trading systems, market participants, spot and currency derivatives.

The foreign exchange FOREX market provides the physical and institutional structure through which the money of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are physically completed. A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified rate. Foreign exchange in general means the money of foreign country that is foreign currency bank balances, banknotes, checks and draft. The purpose of FX market is to facilitate trade and
investment.

There are six main characteristics of the FOREX markets which will be discussed The geographic extent The three main functions The markets participants Its daily transaction volume Types of transactions including spot, forward and Swaps Motivation for transaction Methods of stating exchange rates, quotations, and changes in exchange rates Geographically, the FOREX market spans the globe with prices moving and currencies trading on a 24 hour basis Major world trade starts each morning in Sydney and Tokyo, moves west to Hong Kong and Singapore, passes on Bahrain, and shifts to European markets of Frankfurt, Zurich, London and on to New York, Chicago, San Francisco. The market is deepest or most liquid early in the European afternoon, when the markets of both Europe and East US cost are open. At the end of the day in California, when the traders in Tokyo and Hong Kong getting for next day the market is thinnest. Many large international banks operate foreign exchange operating rooms in each geographic trading center in order to serve important commercial accounts on a 24-hour a day basis. The foreign exchange departments of many nonbank business firms are also use computer networks to keep in touch with market and seek best quotations (Reuters, Telerate, Bloomberg best suppliers)

Functions of the FOREX Market

The FOREX market is the mechanism by which participants transfer purchasing power between countries, obtains or provides credit for international trade, and minimizes exposure to exchange rate risk Transferring of purchasing power is necessary because international trade and capital transactions normally involve parties in countries with different currencies yet each party wishes to transact in their own currency. Each party usually wants to deal in its own currency but the trade can be invoiced only in one single currency. Provision of Credit. Because the movement of goods between countries takes time, inventory in transit must be financed. The FOREX market provides a source of credit via specialized instruments such as letters of credit Minimizing foreign exchange risk. The FOREX market provides hedging facilities for transferring foreign exchange risk to someone else more willing to carry that risk. Market Participants The FOREX market consists of two tiers, the interbank or wholesale market, and the client or retail market. Individual transactions in the interbank market usually involve large sums that are multiples of million US dollars.

Five broad categories of participants operate within these two tiers: Bank and non bank foreign exchange dealers They operates both the interbank and client markets These participants profit from buying currencies at a bid price and then reselling them at an offer or ask price Competition among dealers narrows the spread between the bid and offer rate contributing to the markets efficiency Dealers on behalf of large international banks often act as market makers, often willing to stand in and buy or sell those currencies which they specialized by maintaining an inventory position. They trade amongst other banks and dealers in order to keep their inventory levels at manageable levels Currency trading is profitable and often contributes between 10% - 20% of a banks average net income Small- to medium-sized banks rarely act as market makers yet still participate in the interbank market Individuals and firms conducting commercial or investment transactions Importers, exporters, portfolio investors, MNEs, tourists and others use the FOREX market to facilitate execution of commercial or investment transactions Some of these participants use the market to hedge foreign exchange rate risk Speculators and arbitragers Speculators and arbitragers seek to profit from trading in the market itself They operate for their own interest, without need or obligation to serve clients or ensure a continuous market

 Speculators seek all their profit from exchange rate changes Arbitragers try to profit from simultaneous differences in exchange rates in different markets A large proportion of speculation and arbitrage is conducted on behalf of major banks by traders employed by those banks Central banks and treasuries Central banks and treasuries use the market to acquire or spend their countrys currency reserves as well as to influence the price at which their own currency trades They may act to support the value of their currency because of their governments policies or obligations or because of commitments entered through joint float agreements such as the European Monetary System Consequently their motive is not to profit but rather influence the foreign exchange value of their currency in a manner that will benefit their interests Foreign exchange brokers Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction For this service they charge a small commission They maintain instant access to hundreds of dealers worldwide via open lines and at times may maintain such lines with several banks, with separate lines for differing currencies, spot and forward rates Transactions in the Interbank Market. Transactions within this market can be executed on a spot, forward, or swap basis A spot transaction requires almost immediate delivery of foreign exchange A forward transaction requires delivery of foreign exchange at some future date A swap transaction is the simultaneous exchange of one foreign currency for another Spot Transactions A spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day. THE Canadian dollar settles with the US $ on the first following business day The settlement date is often referred to as the value date This is the date when most dollar transactions are settled through the computerized Clearing House Interbank Payment Systems (CHIPS) in New York. Typical spot transaction in interbank market might involve US bank on Monday contracting for transfers of 10000000 pounds to the account of London bank. If the spot exchange rate is $1,6948/ pound, the US bank would transfer 10000000 pounds on Wednesday and London bank would transfer $16,948000 to US bank at the same time. Outright Forward Transactions This transaction requires delivery at a future value date of a specified amount of one currency for another The exchange rate is agreed upon at the time of the transaction, but payment and delivery are not required until maturity. Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months Terminology typically used is buying or selling forward A contract to deliver dollars for euros in six months is both buying euros forward for dollars and selling dollars forward for euros Swap Transactions A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

Both purchase and sale are conducted with the same counterpart A common type of swap is a spot against forward The dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market Since this transaction occurs at the same time and with the same counterpart, the dealer incurs no exchange rate exposure Forward-forward swaps A dealer sells 20,000 forward for dollars for delivery in two months at $1.6870/ and simultaneously buys 20,000 forward for delivery in three months at $1.6820/ The difference between the buying and selling price is equivalent to the interest rate differential Thus a swap can be viewed as a technique for borrowing another currency on a fully collateralized basis Non-deliverable forwards (NDFs) NDFs possess the same characteristics as traditional forward contracts except that they are settled only in US dollars and the foreign currency being sold or bought forward is not delivered The dollar-settlement feature reflects the fact that NDFs are contracted offshore and are beyond the reach and regulatory frameworks of the home country governments Pricing of NDFs reflects basic interest rate differentials
The derivatives that will be discussed will be

Foreign Currency Futures - It calls for future delivery of a standard amount of currency at a fixed time and price Foreign Currency Options - is a contract giving the purchaser of the option the right to buy or sell a given amount of currency
at a fixed price per unit for a specified time period

Size of the FOREX Market The Bank for International Settlements (BIS) estimates that daily global net turnover in traditional FOREX market activity to be US$1,210 billion in April 2001. There is huge increase in electronic trading, primarily through such benefits as faster execution; convenience, efficiency, productivity; tight spreads; straight through processing; reduction in trsde errors; increased liquidity
2. Motivations beyond trading in foreign exchange markets (arbitrage, speculation, hedging), European and American quotation, direct and indirect quotation, cross rates. Motivation for Transaction in Foreign Exchange Market: change of purchasing power - The change in a persons purchasing power is calculated on the basis of the percentage change of the inflation-corrected purchasing power in two consecutive years. Or its also motive for losing liability: Assets 30mil CZK CzCompany 1 mil USD liability

So Czech company has a liability of 1 mil USD, but as assets it has a bank account which amounted by 30 mil CZK. As spot rate is 20.5 USD/CZK company can buy 1 mil USD liability, which mean to lose it at all. Speculation according to book: Speculation is an attempt to profit by trading on expectations
about prices in the future. In the foreign exchange markets, speculators take an open (unhedged) position in a foreign currency and then close that position after the exchange rate has moved in they

hope- expected direction. Speculation can be undertaken in spot, forward or oprion markets. It has a major impact on our inebality to accurately forecast future exchange rates. Speculation in the spot market : Speculation in the spot market requires only that the speculator believe the foreign currency will appreciate. The maximum gain is unlimited, and the maximum loss will be ex. 10 000 dollars. Speculation in the forward market: Forward market speculation occurs when the speculator believes that the spot price at some future date will differ from todays forward price for that same date. Success does not depend on the direction of movement of the spot rate, but on the relative position of the future spot rate and the current forward rate.

Speculation in Option markets: Options differ from all other types of financial instruments in the patterns of risk they produce. The option owner has the choice of exercising the option or allowing it to expire unused. The owner will exercise it only when exercising is profitable, it means only when the option is in the money. In the case of call option, as the spot price of the underlying currency moves up, the holder has the possibility of unlimited profit. On the downside, the holder can abandon the option and walk away with a loss never greater than the premium paid.

Buyer of a Call

Writer of a Call

Buyer of a Put

Writer of a Put

Speculation the financial manager takes a position in the expectation of profit. Is a financial action
that does not promise safety of the initial investment along with the return on the principal sum. Speculation typically involves the lending of money or the purchase of assets, equity or debt but in a manner that has not been given thorough analysis or is deemed to have low margin of safety or a significant risk of the loss of the principal investment. Speculators may rely on an asset appreciating in price due to any of a number of factors that cannot be well enough understood by the speculator to make an investment-quality decision. Some such factors are shifting consumer tastes, fluctuating economic conditions, buyers' changing perceptions of the worth of a stock security, economic factors associated with market timing, the factors associated with solely chart-based analysis, and the many influences over the short-term movement of securities. Financial speculation can involve the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable financial instrument to profit from fluctuations in its price, irrespective of its underlying value. As second motive speculation means that value of liability discussed in first case is changing as spot rate is changing. Speculation can be passive when the company does not use it as an activity. Passive classifies on: Short exposure Liability in USD is > than Assets in USD, so u as Czech company expect appreciation of CZK, because as CZK appreciate it mean you have to pay less in order to buy liability of 1 mil USD. Long exposure Assets in USD is >Liability in USD. Active speculation when company straightly uses it in its activity. Benefits of speculation: If a certain marketfor example, pork bellieshad no speculators, then only producers (hog farmers) and consumers (butchers, etc.) would participate in that market. With fewer players in the market, there would be a larger spread between the current bid and ask price of pork bellies. Any new entrant in the market who wants to either buy or sell pork bellies would be forced to accept an illiquid market and market prices that have a large bid-ask spread or might even find it difficult to find a co-party to buy or sell to. A speculator (e.g. a pork dealer) may exploit the difference in the spread and, in competition with other speculators, reduce the spread, thus creating a more efficient market.

Hedging - the financial manager uses the instruments to reduce the risks of the

corporations cash flow. Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. An example of a hedge would be if you
owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge). Is a specific activity through which company can decide to close exposure, so that company profits will not be influence by changing of spot rate.

Asset

Cz comp

Liability

Forwards 1 mio USD At fixed prices 17,2 USD/CZK Spot rate = 17 USD/CZK T=1 month

T maturity. Future maturity means you will receive in future USD that u buy now (17-17,5) *1 mio USD = -500000 CZK so u loss 17, 5 spot rate at which u buy But with hedging: u fixes your position in future (17-17,2)*1mio= -200000 still loss, but less than without hedging

Arbitr je zpsob jak vyut vhody odlinch cen na rznch trzch. V zsad to mohou bt mstn oddlen trhy (pak se jedn o mstn arbitr), anebo asov oddlen trhy spotov a termnov (pak se jedn o asovou arbitr). Tm e identick zbo kupujeme na jednom trhu a prodvme na jinm trhu za rzn ceny, dosahujeme bezrizikovho zisku. Psobenm arbitr se vak nakonec ceny srovnvaj. Aby nebylo mono provdt arbitr, me bt rozdl mezi cenami na jednotlivch trzch rovn maximln transaknm nkladm peveden zbo mezi tmito trhy. Mstn arbitr: V Praze se prodv (i vykupuje) jeden kus uritho zbo za 2000 K. V Brn se tot zbo prodv (i vykupuje) za 3000 K. Tedy koupme co nejvc tohoto zbo v Praze za 2000 K a odvezeme jej do Brna, kde za nj dostaneme 3000 K za kus. Bezrizikov jsme vydlali na jednom kusu 1000 K minus nklady na dopravu a dal souvisejc nklady. Realizovali jsme mstn arbitr, tzn. vyuili jsme rozdlu ceny na trhu v Praze a ceny na trhu v Brn. Cena v Praze bude nsledkem tchto arbitrnch obchod rst a v Brn klesat, dokud rozdl mezi cenami nebude maximln roven nkladm na dopravu tohoto zbo z Prahy do Brna (transaknm nkladm). asov arbitr: asov arbitr vypad podobn, jen se nejedn o 2 msta, ale o 2 asy. Nicmn nikdo nev jist jakou bude mt nco cenu za del dobu, pokud na to ovem nem uzavenfinann derivt. Tak me nyn na spotovm trhu vstoupit do jedn pozice a zrove vstoupit na termnovm trhu do jin pozice a dky rozdlm v cen na tchto 2 trzch realizovat bezrizikov zisk. Transakn nklady vyplvaj z doby od uzaven obou pozic do realizace termnovho obchodu a mohou mt podobu nklad skladovacch (pokud se jedn okomodity), rokovch (pokud se jedn nap. o depozitum) atd. Urit zbo se prodv za cenu 2000 K za kus. Mme monost vstoupit do derivtu, kter nm zajist prodej tohoto zbo za 3 msce za cenu 3000 K/ks. Pitom vme, e cena tohoto zbo na trhu se nemn. Nakoupme tedy co nejvce kus tohoto zbo a na vechny uzaveme derivt na jejich prodej za 3000 K. Realizovali jsme asovou arbitr - vyuili jsme rozdlu ceny na spotovm trhu (2000 K) a na termnovm trhu (3000 K). V ppad derivt je jejich cena stanovena prv s ohledem na to, aby nebylo mono provdt takovouto asovou arbitr. Cena derivt je samozejm utvena nabdkou a poptvkou, ale vdy se bude pohybovat v mezch nedovolujcch arbitr, jinak bude prv psobenm arbitrar do tchto mez brzy vrcena. Monosti arbitre jsou s rostoucglobalizac stle ni, protoe se zvtujcm se mnostvm hr na trhu se zvyuje tak jeho likvidita i efektivita. Dvojstrann/Pm arbitr je devizov operace, kter umouje dealerovi doshnout zisku na zklad existujcho doasnho rozdlu mezi kurzem pslun mny na rznch mstech devizovho trhu. Pklad: Banka A ktuje kurz mezi dvma stejnmi mnami odlin ne banka B (meme na tom jednodue vydlat) , ale: Prostor pro pmou kurzovou arbitr v dnench podmnkch modern techniky, kter rychle zprostedkovv vechny potebn informace je

Arbitrage

minimln. Trojstrann/nepm arbitr souvis s pravidlem kovho kurzu. Kov kurz je kurz mezi dvma mnami, odvozen z pomru kurzu tchto mn ke tet mn. Jestlie znm kurz USD v CHF a USD v EUR, pak je mon na zklad kovho pravidla odvodit kurz CHF k EUR: CHF/USD UER/USD = CHF/EUR Kurz se ale tvo na devizovm trhu v kadm danm okamiku podle vvoje poptvky a nabdky pslun devizy. Me tedy nastat situace, kdy na uritm mst devizovho trhu nebude kurz CHF/EUR odpovdat kovmu pravidlu. V tom ppad me vzniknout proctor pro strojstrannou kurzovou arbitr meme na tom vydlat.

Arbitrage: The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. So you buy a financial instrument and sell at the same time, doing profit without any risk. If I can buy an asset for $5, turn around and sell it for $20 and make $15 for my trouble, that is arbitrage. The $15 I gain represents an arbitrage profit. Arbitrage exists as a result of market inefficiencies.

Arbitrage is possible when one of three conditions is met: 1. The same asset does not trade at the same price on all markets ("the law of one price"). 2. Two assets with identical cash flows do not trade at the same price. 3. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities). Example: you have 1 mio USD you can buy CHF buy GBP finish arbitrage with USD and if you will get more than 1 mio USD, the arbitrage is profitable BID ASK Dealer1 USD/GBP 0,8527 0,8533 Dealer 2 USD/CHF 1,6230 1,6240 Dealer 3 GBP/CHF 1,9005 1,9015 [1mio USD* 1,6230/ 1,9015] /0,8533 = 1000277,4 USD so arbitrage is profitable Or you also can buy GBP and buy GBP and finish arbitrage with USD [1 mio USD* 0,8527*1,9005] / 1,6240 = 997879,5 USD in this case arbitrage is not profitable Intermarket Arbitrage Cross rates can be used to check on opportunities for intermarket arbitrage, where equilibrium price dont open possibility for arbitrage. A foreign exchange quote is a statement of willingness to buy or sell at an announced rate In the retail market (newspapers and exchange booths), quotes are often given as the home currency price of the foreign currency. So exchange rate is relative price between two currencies. Or its is price of 1 unit of one currency in terms of second currency. Interbank quotes professionals state forex quotes in one of two ways: European quotation: price of 1 unit of EUR in terms of CZK

American quotation: price of USD in terms of 1 unit of national currency ( dealer prefer this quotation) So the EUR and USD is a vehicle or leading currencies.

Direct and Indirect Quotes A direct quote is a home currency price of a unit of a foreign currency

An indirect quote is a foreign currency price in a unit of the home currency

Exchange Rate Quotation European vs. American quotation Bid and Ask Quotations Interbank quotes are given as a bid and ask The bid is the price at which a dealer will buy another currency The ask or offer is the price at which a dealer will sell another currency. Example: 118.27 - 118.37/$ is the bid/ask for Japanese yen The bank will buy yen at 118.27 per dollar and sell yen at 118.37 per dollar making profit on the spread Many currencies pairs are inactively traded, so their exchange rate is determined through their relationship

Cross Rates

to a widely traded third currency. Cross rate between currencies where there is no leading currency and they are equal. Cross rate European quotation

Tokyo. Both the Mexican peso (Ps) and Japanese yen () are quoted in US dollars Assume the following quotes: Japanese yen 121.13/$ Mexican peso Ps9.190/$ Cross rate American quotation

Example: A Mexican importer needs Japanese yen to pay for purchases in

3. Forward contract, main characteristics, outright forward rate calculation and quotation, forward contract and hedging of open transaction exposure.

Forwardov kurz pedstavuje realizan cenu, pi kter se realizuj forwardov obchody. Forwardov kontrakt je sekundrn neobchodovateln dohoda mezi dvma protistranami o smn dvou specifickch mn v budoucm termnu za pedem dohodnutou cenu. Forward quotations: 1.) Outright quotation uvd pmo cel kurzov hodnoty pro forwardov kurzy: sted, nkup a prodej. Plat zkonitost, e spread u forwardovch kurz (=rozpt mezi nkupnm a prodejnm kurzem) narst s dobou splatnosti forwardovho kotraktu. 2.) Quotation in percentages viz strana 54. 3.) Quotation in SWAP points udv v ppad pm quotation pouze rozdl forwardovho kurzu outright a spotovho kurzu outright: swap points = (FR SR) . X piem nsobenm slem X pevdme vsledek na cel sla (tzv.body). pi tradin kotaci na tyi desetinn msta bude X mt hodnotu 10 000. Kladn hodnota tohoto rozdlu pedstavuje tzv.prmii a zporn tzv.diskont.

A forward contract is an agreement between two parties to buy or sell an asset at a specified point of time in the future. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. The forward price of such a contract

is commonly contrasted with the spot price, which is the price at which the asset changes based on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. This process is used in financial operations to hedge risk, as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. Most forward contracts don't have standards and aren't traded on exchanges. A farmer would use a forward contract to "lock-in" a price for his grain for the upcoming fall harvest. A closely related contract is a futures contract; they differ in certain respects. The difference between a forward contract and most other sales contracts is that with the forward contract, the delivery and payment of the underlying instrument occurs at a specified future date instead of immediately. Example: Suppose that Bob wants to buy a house in one year's time. At the same time, suppose that Andy currently owns a $100,000 house that he wishes to sell in one year's time. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract. At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one needs only to recognize that Bob can buy from Andy for $104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,00 Main Characteristics of Outright Forwards Maturity: 1M, 2M, 3M, 6M, 9M, 12M + odd dates Price: bid/ask forward rate (FR) Currency pairs: as in case of spot contracts Amount: minimum defined by the market maker Interest Rates: interbank deposit/lending rates yields of treasury instruments Time conventions: act/360 or act/365 Forward Rate Calculation and Quotation (outright quotation) Example:

Conclusion of calculation: FR is very close to SR, because our currency (EUR) has less IR than other Pros and cons of outright forwards: Arguments for outright forwards: Main instrument for FX exposure management Easy and cheap way how to obtain fixed exchange rate Possibility how to lower volatility of cash-flow

Arguments against outright forwards: Suitable only for transactions with known amount and maturity Suitable only for static examples of FX exposure Forward Quotations in Percentage Terms Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate This is similar to the forward discount or premium will be shown in next question 4 The important thing to remember is which currency is being used as the home or base currency For indirect quotes (i.e. quote expressed in foreign currency terms), the formula is

For direct quotes (i.e. quote expressed in home currency terms), the formula is

Hedging is the taking of a position that will rise (fall) in value and offset a fall (rise) in the value of an existing position.While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset hedged against. A forward hedge involves a forward (or futures) contract and a source of funds to fulfill the contract. In some situations, funds to fulfill the forward exchange contract are not already available or due to be received later, but must be purchased in the spot market at some future date. This type of hedge is open or uncovered. So, with A Forward contract u will lock in an exchange rate at which the transaction will occur in the future. (u fixed your position in future)
4. Interest rate parity and covered interest rate arbitrage, forward (swap) points calculation, forward premium/discount.

Interest Rate Parity (IRP) Interest rate parity theory provides the linkage between foreign exchange markets and international money markets The theory states that the difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite sign to, the forward rate discount or premium for the foreign currency, except for transaction costs. Unlike the Fisher effect, the theory is applicable only to securities with maturities of one year or less, as forward contracts are not routinely available for periods longer than one year.

Ignoring transaction costs, if the returns in $ are equal between the two alternative money market investments, the spot and forward rates are considered to be at interest rate parity. The transaction is covered because the exchange rate back to $ is guaranteed to the end of 90 day period.

The process of covered interest arbitrage drives the international currency and money markets toward the equilibrium described by interest rate parity. Slight deviations from equilibrium provide opportunities for arbitrages to make small riskless profit. Such deviations provide supply and demand forces that will move the market back toward parity (equilibrium). Covered interest arbitrage should continue until interest rate parity is reestablished, because the arbitragers are able to earn risk-free profits by repeating the cycle as often as possible. A deviation from CIA is uncovered interest arbitrage, UIA, wherein investors borrow in currencies exhibiting relatively low interest rates and convert the proceeds into currencies which offer higher interest rates. The transaction is uncovered because the investor does not sell the currency forward, thus remaining uncovered to any risk of the currency deviating

Exhibit with graph illustrate conditions necessary for equilibrium between interest rates and exchange rates using. The vertical axis is %difference between foreign and domestic IR. Horizontal forward premium and discount on the currency. The IRP line shows the equilibrium state, but transaction costs cause the line to be band rather than thin line. Equilibrium - where -4% interest differential on currency securities would be offset by 4% premium on forward yen (currency). Forward Rate Calculation and Quotation Example of high points/low points quotation Conclusion of calculation: quotation 10/ 9 not correct BID>ASK Always BID should be less than ASK BID<ASK

Bruna gave other formula: FR > SR base currency is at premium and quoted currency is at discount quoted as low points/high points FRBID = SRBID + low points FRASK = SRASK + high points

FR < SR base currency is at discount and quoted currency is at premium quoted as high points/low points FRBID = SRBID - high points FRASK = SRASK - low points
5. Foreign exchange swaps, main characteristics, swap points, foreign exchange swaps and management of liquidity, types of foreign exchange swaps (spot/forward, forward/forward, short dates). HISTORY Foreign exchange swaps have appeared for some time in the intervention toolkit of many central banks around the world, although their popularity seems to be on the wane. In a Bank for International Settlements survey taken in 1997 (BIS 1997, p. 332), seven of fourteen industrialcountry central banks surveyed listed foreign exchange swaps against either the U.S. dollar or the deutsche mark (or both) among the tools used to conduct open market intervention. Of those seven, fiveAustria, Belgium, Germany, Italy, and the Netherlandsdiscontinued foreign exchange operations when they became part of the European Monetary Union. Of the remaining two, Australia and Switzerland, only the latter has used foreign exchange swaps extensively, at some point as its main intervention tool, with the total amount of swaps hovering for years at about 40 percent of the monetary base. This use partly reflected the limited depth of domestic debt markets associated with limited fiscal deficits historically incurred by the Swiss government.

Swap transaction to swap currencies for the specified period of time. Advantages of swaps:
Swaps can be used for cash flows regulation; Swaps can be used for extension of forwards; Swaps can be made even for 12 months period. Foreign exchange swap An Agreement between 2 counterparties to exchange stipulated (identical) amounts of one currency for another with two different value dates.

A forex swap consists of two legs:

a spot foreign exchange transaction, and a forward foreign exchange transaction.

These two legs are executed simultaneously for the same quantity, and therefore offset each other. It is also common to trade forward-forward, where both transactions are for (different) forward dates. A Foreign Exchange Swap has two settlement dates:

the start date, when a currency is first exchanged for another at an agreed exchange rate; and the end date when the currencies are exchanged back at an agreed exchange rate. The exchange rate for each of the transactions is usually different and this difference is called swap points. Swap points are set by the market and will generally reflect the current interest rates of the two countries involved for the term of the Foreign Exchange Swap. They are added to, or subtracted from, the spot rate. Formally, a foreign exchange (FX) swap is a financial transaction whereby two parties exchange agreed-upon amounts of two currencies as a spot transaction, simultaneously agreeing to unwind the exchange at a future date, based on a rule that reflects both interest and principal payments. When the initiating agent is a central bank, the motivation for undertaking the swap is usually either to affect domestic liquidity or to manage foreign exchange reserves. (Rarely, central banks have been known to use currency swaps for the main purpose of hedging and asset liability management.)

A contributing reason why FX swaps have not been particularly popular as tools for monetary control is that FX transactions normally are settled on the second business day following the trade, in part because the transaction typically involves a transfer of liabilities between central banksso as to debit the sending partys account and credit the receiving partys accountand the two central banks may be in different time zones. This results in a delivery lag equal to at least countrys local time for final settlement.1 This arrangement makes FX swaps ill-suited for swift action and has caused several countries using FX swaps to routinely renew them at maturity, leaving the burden for high frequency liquidity control to alternative instruments. The relative scarcity of banks sufficiently large and endowed with foreign currency on hand to act as counterparties has also contributed adversely to the diffusion of FX swaps as instruments for liquidity control. By virtue of combining a spot and a forward transaction, FX swaps can also be priced easily, based on available forward quotations and, generally, satisfying the covered interest parity condition. Viewing swaps essentially as forward transactions also highlights requirements for their effective use namely, price stability, depth of the underlying forward market, and ready availability of quotes requirements that have led most central banks active in the swap market to undertake operations mostly in U.S. dollars or, until 1998, deutsche marks.

Types of foreign exchange swaps

The most common foreign exchange swap is to combine a spot transaction with a forward transaction. It is a transaction of foreign exchange in which the customer, at the time when selling Currency A and buying Currency B, buys the forward Currency A and sells the forward Currency B in converse directions.
EXAMPLE OF Foreign Exchange Swap Transaction http://www.fxcenterusa.com/us/learning/FX %20Swaps.pdf

If both dates are less than one month from the deal date, it is a short-dated swap. Short dated (swaps) Swaps, usually of one currency for another, which span periods of less than one week. Overnight Dealing today for tomorrow. It can also refer to the shortest short-date swap and the most commonly used. This would involve a simultaneous purchase and sale (of currencies), of which the first transaction is settled today and the reverse transaction settled tomorrow. Spot/next A term applied to a currency transaction for spot value against that of the next working day (ie, three working days hence, assuming 'spot' is two-day value). Tom/next Foreign-exchange market shorthand for tomorrow/next day. It refers to a form of short-date swap, mainly used to try to maximise return on funds. For example, a trader with a surplus of, say, $US has a choice of lending the $US or selling them for $A, investing the $A and buying back the $US next day. If the $A interest rates are higher, it could be more profitable to swap the $US for $A and invest the $A than simply to lend the $US. Thus the trader would (today) sell the $US and buy the $A for settlement tomorrow (tom) and at the same time would buy back the $US and sell $A for settlement the next day (next). The tom/next swap is frequently used in the Australian currency hedge market to try to minimise exposures peculiar to the settlement process of that market. 6. Currency swaps, main characteristics, cost of home and foreign financial funds, hedging of foreign exchange risk of foreign currency denominated debt. Begin with example: Czech company invests into a specific project 500 mil. CZK. Problem: How to get the funds? IPO = Initial public offering(or stock market launch, is the first sale of stock by a company to the public. It can be used by either small or large companies to raise expansion capital and become publicly traded enterprises.) , BONS = external financing Two possibilities:

A) Czech company issue BONS in CZK, 4 years, 5% IR, the company knows, it will be hard to pay the bons in 4 years. You pay 5% IR for each year this will receive investor B) Czech company can issue foreign BONS, 20 mil. EUR, 4 years, paying 4% IR for each year B is better, but the problem is the foreign currency exposure thats expensive Currency swap = agreement between 2 counter part. (Czech company and bank) T T+1 T+2 T+3 T+4 - 20 mil EUR + 20 mil EUR (company decide to sell it and receive 500 mil CZK) - 500 mil CZK + 500 mil CZK + 4% of 20 mil EUR (company received) - 4,9% of 500 mil CZK It better than alternative A Main Business Problems with currency swaps: differences between home and foreign longterm external financing funds, costs of home and foreign financing, main risks of long-term external financing

Currency swaps umouj konverzi pravidelnch plateb v jedn mn do pravidelnch plateb v jin mn. Z hlediska swapu rokovch plateb me jt o swap fixovan rokov sazby v jedn mn do fixovan rokov sazby v druh mn (fixed to fixed swap) nebo o swap pohybliv rokov sazby v jedn mn do pohybliv rokov sazby ve druh mn (floating to floating swap) Cross currency interest rate swaps umouj dale pemnu fixovan rokov sazby v jedn mn do pohybliv rokov sazby v druh mn (fixed to floating swap) a nebo opan (floating to fix swap), Mnov a mnov rokov swapy tedy umouj konverzi dluhov sluby v jedn mn do jin mny. Na rozdl od tradinch swap, kter jsou krtkodob a jednorzov, umouj currency swaps a cross currency interest rate swaps pemnu pravidelnch plateb vyplvajcch z dlouhodbch zvazk. Zkladnm lnkem swapovho trhu, kter je uspodn tzv. Formou over the counter jsou banky, respective jejich specializovan dceinn spolenosti - swap house .. dale viz pklad str. 132 Agreement between 2 counterparties about exchanges the principles of 2 different currencies at 2 different value dates.

A currency swap (or cross currency swap) is a foreign exchange agreement between two parties to exchange principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal (regarding net present value) loan in another currency. Currency swaps are motivated by comparative advantage. Currency swaps were introduced by the World Bank in 1981 to obtain Swiss franks and German marks by exchanging cash flows with IBM. Currency swaps can be negotiated for a variety of maturities of up to 10 years. Unlike a back-to-back loan, a currency swap is not considered to be a loan by United States accounting laws and thus it is not reflected on a company's balance sheet. A swap is considered to be a foreign exchange transaction (short leg) plus an obligation to close the swap (far leg) being a forward contract. Unlike interest rate swaps, currency swaps involve the exchange of the principal amount. Interest payments are not netted (as they are in interest rate swaps) because they are denominated in different currencies. Further, many currency swaps are traded on organized exchanges - lowering counter-party risk, as evidenced by the bid-ask spread on most listings. Currency swaps are often combined with interest rate swaps. For example, one company would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a floating-rate debt denominated in Euro. This is especially common in Europe where companies shop for the cheapest debt regardless of its denomination and then seek to exchange it for the debt in desired currency. For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based company needs to acquire U.S. dollars. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap maturities are negotiable for at least ten years, making them a very flexible method of foreign exchange. Currency swaps were originally done to get around exchange controls. During the global financial crisis of 2008 currency swaps were offered to other central banks by the Federal Reserve System including stable emerging economies such as South Korea, Singapore, Brazil, and Mexico. the process of a currency swap normally also includes a series of recurring payments based on the cash flow performance of the two currencies. This makes a currency swap somewhat different from a currency exchange, in that the exchange normally involves simply exchanging currency at the most recent rate of exchange. One important aspect of the currency swap that also sets it apart from currency exchanges is the fact that the swapping of the currency is not a permanent component. At the time that the two currencies are swapped, the parties agree to make the recurring interest rate payments for a specific period of time. Once the duration outlined in the agreement is complete, the two currencies are returned to the original owner. However, each party retains all returns that were shared in the form of interest payments. Currency swaps exist because of barriers in international capital markets that caused segmentation. During the 1990s, as product markets became globalized, many countries liberalized their financial markets, and as they did so, the currency swap market grew from $1.197 trillion in 1995 to $10.772 trillion in 2006. We show that the economic exposure of firms affects financing strategy and continued use of currency swaps. When firms face positive economic exposure, use of home currency debt with currency swaps dominates both foreign currency debt financing and home currency debt financing. When firms face negative economic exposure, foreign currency debt financing dominates.

7. Currency futures contract, main characteristics, futures exchange, futures price quotation and calculation, relationship between spot rate and futures price (basis risk). Futures kontrakty na nkup nebo prodej deviz maj urit zkladn znaky shodn s forwardovmi operacemi. Jde rovn o termnov obchod, kde uzaven kontraktu (dohoda o cen a mnostv) probh v ptomn dob, zatmco plnn se uskuteuje a v budoucnu. Narozdl od forwardovch operac nen vak tento typ devizov operace uskuteovn prostednictvm neorganizovanho trhu over the counter , ale pomoc organizovanho trhu burzy. Obchody probhaj na elektronickch burzch nebo tradin metodou veejn draby. Hlavn vznamnou odlinost futures oproti forwardovm kontraktm, je monost okamitho vyrovnn zisku i ztrty po uzaven pozice

opanou operac (ke stejnmu datu splatnosti a ve stejnm mnostv). Obvykle se uvd, e 95% obchod futures je ukneno ped dobou splatnosti. Dal zkladn odlinost od forwards je vt standardizace kotrakt. Standardovn jsou zejmna mnostv obchodovanch deviz. Konkrtn jsou stanovena zkladn minimln obchodovateln mnostv loty. Smyslem standardizace je zajistit vt kocentraci nabdky a poptvky a tm I vt likviditu trhu. Odlinosti oproti forwardm spovaj I v tom, e obchody s futures se uzavraj vhradn prostednictvm brokers and traders operujch na parketu, kte jsou leny burzy a jejich poet je tedy omezen. Klienti, kte uzavou kontrakt futures na nkup nebo prodej deviz prostednictvm system zprostedkovatel, nemaj po uzaven obchodu bezprostedn prvn vztah vi sob navzjem, ale ke clearingov stedn na burze. Velkou vhodou futures je monost okamitho vyrovnn konenho kurzovho zisku nebo ztrty s clearingovou stednou po uzaven protipozice. Faktory ovlivujc pohyb kurz futures vlastn pohyb kurzu futures ovlivuj ti zkladn factory: - hodnota sport rate - rove rokovch sazeb (na ronm zklad) pro pslun dv mny (IR) - zbvajc doba do splatnosti futures kontraktu (t) Zajitn pomoc futures pi odlin splatnosti zajiovahho zvazku: Pokud m zajiovan zvazek nebo pohledvka stejnou dobu splatnosti jako nabzen kontrakt futures, je zajitn obdobn jako na forwardovm trhu. Futures trh vak nabz pouze 4 splatn termny bhem roku, co obvykle neumouje tento jednoduch zpsob zajitn. - A transferable futures contract that specifies the price at which a specified currency can be bought or sold at a future date. Currency future contracts allow investors to hedge against foreign exchange risk. Since these contracts are marked-to-market daily, investors can--by closing out their position--exit from their obligation to buy or sell the currency prior to the contract's delivery date. A currency future, also FX future or foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date. Typically, one of the currencies is the US dollar. The price of a future is then in terms of US dollars per unit of other currency. This can be different from the standard way of quoting in the spot foreign exchange markets. The trade unit of each contract is then a certain amount of other currency, for instance 125,000. Most contracts have physical delivery, so for those held at the end of the last trading day, actual payments are made in each currency. However, most contracts are closed out before that. Investors can close out the contract at any time prior to the contract's delivery date.

History
Currency futures were first created at the Chicago Mercantile Exchange (CME) in 1972, less than one year after the system of fixed exchange rates was abandoned along with the gold standard. Some commodity traders at the CME did not have access to the inter-bank exchange markets in the early 1970s, when they believed that significant changes were about to take place in the currency market. They established the International Monetary Market (IMM) and launched trading in seven currency futures on May 16, 1972. Today, the IMM is a division of CME. In the second quarter of 2005, an average of 332,000 contracts with a notional value of $43 billion were traded every day. Currently most of these are traded electronically. Other futures exchanges that trade currency futures are Euronext.liffe and Tokyo Financial Exchange The IMM dates are the third Wednesday in March, June, September and December.

Hedging

Investors use these futures contracts to hedge against foreign exchange risk. If an investor will receive a cash flow denominated in a foreign currency on some future date, that investor can lock in the current exchange rate by entering into an offsetting currency futures position that expires on the date of the cash flow. For example, Jane is a US-based investor who will receive 1,000,000 on December 1. The current exchange rate implied by the futures is $1.2/. She can lock in this exchange rate by selling 1,000,000 worth of futures contracts expiring on December 1. That way, she is guaranteed an exchange rate of $1.2/ regardless of exchange rate fluctuations in the meantime.

Speculation

Currency futures can also be used to speculate and, by incurring a risk, attempt to profit from rising or falling exchange rates. For example, Peter buys 10 September CME Euro FX Futures, at $1.2713/. At the end of the day, the futures close at $1.2784/. The change in price is $0.0071/. As each contract is over 125,000, and he has 10 contracts, his profit is $8,875. As with any future, this is paid to him immediately. Edit: Quoting for FX Futures at CME is in /$ not $/! More generally, each change of $0.0001/ (the minimum Commodity tick size), is a profit or loss of $12.50 per contract.}} In finance, a futures contract is a standardized contract, to buy or sell a specified commodity of standardized quality at a certain date in the future, at a market determined price (the futures price). The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. In many cases, the items may be such non-traditional "commodities" as foreign currencies, commercial or government paper [e.g., bonds], or "baskets" of corporate equity ["stock indices"] or other financial instruments. They are traded on a futures exchange. The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange[1] at a price specified today. A futures contract gives the holder the obligation to make or take delivery under the terms of the contract, whereas an option grants the buyer the right, but not the obligation, to establish a position previously held by the seller of the option. In other words, the owner of an options contract may exercise the contract, but both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations. Futures contracts, or simply futures, (but not future or future contract) are exchange traded derivatives. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, and crucially also provides a mechanism for settlement.[2]
A futures exchange is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future.

History of futures exchanges

The origins of futures trading can be traced to Ancient Greek, in Aristotle's writings. He tells the story of Thales, a poor philosopher from Miletus who developed a "financial device, which involves a principle of universal application." Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in

his prediction, he made agreements with local olive-press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or pathetic and because the olive-press owners were willing to hedge against the possibility of a poor yield. When the harvest-time came, and many presses were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a large quantity of money The recent history of these exchanges (Aug 2006) finds the Chicago Mercantile Exchange trading more than 70% of its Futures contracts on its "Globex" trading platform and this trend is rising daily. It counts for over 45.5 Billion dollars of nominal trade (over 1 million contracts) every single day in "electronic trading" as opposed to open outcry trading of Futures, Options and Derivatives. In June 2001, ICE (IntercontinentalExchange) acquired the International Petroleum Exchange (IPE), now ICE Futures, which operated Europes leading open-outcry energy futures exchange. Since 2003, ICE has partnered with the Chicago Climate Exchange (CCX) to host its electronic marketplace. In April 2005, the entire ICE portfolio of energy futures became fully electronic. In 2006, the New York Stock Exchange teamed up with the Amsterdam-Brussels-LisbonParis Exchanges "Euronext" electronic exchange to form the first trans-continental Futures and Options Exchange. These two developments as well as the sharp growth of internet Futures trading platforms developed by a number of trading companies clearly points to a race to total internet trading of Futures and Options in the coming years. In terms of trading volume, the National Stock Exchange of India in Mumbai is the largest stock futures trading exchange in the world, followed by JSE Limited in Sandton, Gauteng, South Africa
The contracts traded on futures exchanges are always standardized. In principle, the parameters to define a contract are endless (see for instance in futures contract). To make sure liquidity is high, there is only a limited number of standardized contracts. Each exchange is normally regulated by a national governmental (or semi-governmental) regulatory agency: In Australia, this role is performed by the Australian Securities and Investments Commission. In the Chinese mainland, by the China Securities Regulatory Commission. In Hong Kong, by the Securities and Futures Commission. In India, by the Securities and Exchange Board of India and Forward Markets Commission (FMC) In the UK, futures exchanges are regulated by the Financial Services Authority. In the USA, by the Commodity Futures Trading Commission.

The Basics of Currency Futures Contracts

The Basics of Currency Futures Contracts Currency Futures Trading is a contract that specifies the delivery of currencies on a predetermined date and price. Futures require the owner to purchase the currency traded in the future. This represents a pledge for the transaction to take place on the specified date. For price risk insulation, futures contracts are often hedged. Many firms will use currency futures to protect them from the risk of the currency exchange rate that may affect future foreign payables or receivables. Individuals or companies can also use currency contracts as speculative tools for future investments. They hope to benefit by purchasing a future today that they can sell before the maturity of the contract for a profit. Future contracts are put on the market at the end of every day, and if your contract has no money, then you must meet a margin call, or sell your contract. This means that if you

were to close your contract today, you would have to pay a sum as a result of currency fluctuations, you could no longer keep the same contract. There are two different types of margins that must be met when trading futures contracts. These are the initial margin and the maintenance margin. The initial margin is the amount you must have in your margin account to buy future contracts. The maintenance margin is the amount that must be added to your account if your currency rate has moved against your futures contract. If the market is not going your way, you may end up making maintenance margin payments multiple days in a row.
Contract Exchan ge Initial Margin 1,215 2,025 1,350 1,663 3,240 1,755 3,125 2,228 Maintenance Margin 900 1,500 1,000 1,250 2,400 1,300 2,500 1,650 Australian IMM Dollar British Pound IMM Canadian IMM Dollar Dollar Index NYBOT Euro IMM Currency Japanese Yen IMM Mexican Peso IMM Swiss Franc IMM

Margins are subject to change without notice. * Margins involving the spot month may be significantly higher. The currency futures contracts mentioned above are all vs. the USD

Pricing
The situation where the price of a commodity for future delivery is higher than the spot price, or where a far future delivery price is higher than a nearer future delivery, is known as contango. The reverse, where the price of a commodity for future delivery is lower than the spot price, or where a far future delivery price is lower than a nearer future delivery, is known as backwardation. When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a future is determined via arbitrage arguments. The forward price represents the expected future value of the underlying discounted at the risk free rateas any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away; see rational pricing of futures. Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t), will be found by compounding the present value S(t) at time t to maturity T by the rate of risk-free return r. or, with continuous compounding This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. In a perfect market the relationship between futures and spot prices depends only on the above variables; in practice there are various market imperfections (transaction costs, differential borrowing and lending rates, restrictions on short selling) that prevent complete arbitrage. Thus, the futures price in fact varies within arbitrage boundaries around the theoretical price.

The above relationship, therefore, is typical for stock index futures, treasury bond futures, and futures on physical commodities when they are in supply (e.g. on corn after the harvest). However, when the deliverable commodity is not in plentiful supply or when it does not yet exist, for example on wheat before the harvest or on Eurodollar Futures or Federal funds rate futures (in which the supposed underlying instrument is to be created upon the delivery date), the futures price cannot be fixed by arbitrage. In this scenario there is only one force setting the price, which is simple supply and demand for the future asset, as expressed by supply and demand for the futures contract. In a deep and liquid market, this supply and demand would be expected to balance out at a price which represents an unbiased expectation of the future price of the actual asset and so be given by the simple relationship
.

In fact, this relationship will hold in a no-arbitrage setting when we take expectations with respect to the risk-neutral probability. In other words: a futures price is martingale with respect to the risk-neutral probability. With this pricing rule, a speculator is expected to break even when the futures market fairly prices the deliverable commodity. In a shallow and illiquid market, or in a market in which large quantities of the deliverable asset have been deliberately withheld from market participants (an illegal action known as cornering the market), the market clearing price for the future may still represent the balance between supply and demand but the relationship between this price and the expected future price of the asset can break down.

8. Role of margin account for futures trading, daily settlement of profits and losses, speculation and hedging through currency futures. future exchange = future trading similar to question 7 (speculation and hedging above)

Margin and Mark-to-Market

Clearing houses charge two types of margins: the Initial Margin and the Mark-To-Market margin (also referred to as Variation Margin). The Initial Margin is the sum of money (or collateral) to be deposited by a firm to the clearing corporation to cover possible future loss in the positions (the set of positions held is also called the portfolio) held by a firm. In the simplest case, this is the dollar figure that answers a question of this nature: What is the likely loss that this firm may incur on its portfolio with a 99% confidence and over a period of 2 days? The clause 'with a 99% confidence' and 'over a period 2 days' is to be interpreted as that number such that the actual portfolio loss over 2 days is expected to exceed the number only 1% of the time, although how they know this is unknown. Several popular methods are used to compute initial margins. They include the CME-owned SPAN (a grid simulation method used by the CME and about 70 other exchanges), STANS (a Monte Carlo simulation based methodology used by the OCC), TIMS (earlier used by the OCC, and still being used by a few other exchanges like the Bursa Malaysia). The Mark-to-Market Margin (MTM margin) on the other hand is the margin collected to offset losses (if any) that have already been incurred on the positions held by a firm. This is computed as the difference between the cost of the position held and the current market value of that position. If the resulting amount is a loss, the amount is collected from the firm; else, the amount may be returned to the firm (the case with most clearing houses) or kept in reserve depending on local practice. In either case, the positions are 'marked-tomarket' by setting their new cost to the market value used in computing this difference.

The positions held by the clients of the exchange are marked-to-market daily and the MTM difference computation for the next day would use the new cost figure in its calculation. Clients hold a margin account with the exchange, and every day the swings in the value of their positions is added to or deducted from their margin account. If the margin account gets too low, they have to replenish it. In this way it is highly unlikely that the client will not be able to fulfill his obligations arising from the contracts. As the clearing house is the counterparty to all their trades, they only have to have one margin account. This is in contrast with OTC derivatives, where issues such as margin accounts have to be negotiated with all counterparties.

Settlement
Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:

Expiry (or Expiration in the U.S.) is the time and the day that a particular delivery month of a futures contract stops trading and the final settlement price for that contract month and year obtains. For many equity index and interest rate futures contracts (as well as for most equity options), this happens on the third Friday of certain trading month. On this day the t+1 futures contract becomes the t futures contract. For example, for most CME and CBOT contracts, at the expiration of the December contract, the March futures become the nearest contract. This is an exciting time for arbitrage desks, which try to make quick profits during the short period (perhaps 30 minutes) during which the underlying cash price and the futures price sometimes struggle to converge. At this moment the futures and the underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions. On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour.
Question 15: International monetary system, contemporary currency regimes, fixed vs. flexible exchange rate systems in macroeconomic policy and corporate competitiveness, choosing currency regimes in transition countries, project of European Monetary Union. 1) International monetary system International Monetary Systems are sets of internationally agreed rules, conventions and practices that facilitate international trade, cross border investment and generally the reallocation of capital between nation states. The systems can grow organically as the collective result of numerous individual agreements between international economic actors spread over several decades. The pre WWI financial order: 1870 1914 - The world benefited from a well integrated financial order - Latin Monetary Union (Belgium, Italy, Switzerland, France) and Scandinavian monetary union (Denmark, Norway and Sweden) - In the absence of shared membership of a union, transactions were facilitated by widespread participation in the gold standard, by both independent nations and their colonies - Gold standard:

Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). The Nymex crude futures contract uses this method of settlement upon expiration. Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market. Ice Brent futures use this method.

Existed till WWII The basis was gold, the role of which was legally the main form of money Nations exchange rates were firmly pegged to gold; and the foreign exchange parities were taken from the price of gold (e.g. 1 pound = ounce and 1 dollar = ounce, then 1 pound = 5 dollars) o The fluctuations from the fixed foreign exchange rate were extremely small plus/minus 1% - Great Britain was at the time the world's pre-eminent financial power - This era saw mostly steady growth and a relatively low level of financial crises. In contrast to the Breton Woods system, the pre-WWI financial order was not created at a single high level conference; rather it evolved organically in a series of discrete steps Between the World Wars: 1919 1939 - During WWI and especially the Great depression the gold standard experienced crisis - A period of de-globalisation, as both international trade and capital flows shrank compared to the period before WWI - During WWI countries had gradually abandoned the gold standard, besides US - The prevailing order was essentially a fragmented system of floating exchange rates - USA became a new leader and the gold standard was changed - The era of switching from the pure gold standard to a standard, which combined gold and major foreign currencies easily convertible to gold - Appearance of currency blocs = groups of countries, which pegged their national currencies to some currency of a leader country (e.g. pound bloc, dollar bloc) Benefits of a gold standard: 1) stabilization of internal and external economic policy (due to stabilized fx rate and development and growth of the international trade), 2) stabilized fx rate (reliability of forecasts, trust of businesses, better planning of costs and expenses, minimum risk) Cons: 1) dependancy of money supply on the extraction and production of gold (the openings of new deposits and growth of gold supply were assiciated with transnational inflation), 2) impossibility to manage independent monetary policy, which was aimed to solve internal problems The Bretton Woods Era: 1945 1971 - a different fx system was formalized in 1944 in Bretton Woods - two international institutions, the International Monetary Fund (IMF) and the World Bank were created - objective was to create an order that combined the benefits of an integrated and relatively liberal international system with the freedom for governments to pursue domestic policies aimed at promoting full employment and social wellbeing - principles: 1) establishing of the firm fx rates of the countries-participants to the leader country, 2) the currency of the leader country was pegged to gold, 3) central banks supported stabilized their fx rates through fx interventions, 4) the changes in fx rates were done only through devalvation or realvation, 5) IMF was a manager - USA became a leader country (70% of world gold deposits) - however in the beginning of the 70s European gold deposits became more than 4 times bigger, US did not manage to fulfill the demand, problems with international liquidity + the trust in USA decreases because of its enormous deficit in balance of payments, difficult dollar convertibility into gold - creation of new financial centres in West Europe and Japan - the crisis lasts for 10 years The Post Bretton Woods system : 1971 present o o o

in 1976 in conference of IMF in Kingstone the modern international monetary system was established based on flexible or floating exchange fates and multicurrency standard main charactristics: o multicentric system, based on multiple curencies, instead of a single one o monetary parity to a gold is cancelled o the major mean for international transactions became freely convertible currency, Special Drawing Rights (SDR = special rights for ownership represent the cashless money in a form of records on some countrys bill in IMF; only IMF participants can have SDR; is an international reserve asset which was created by IMF to supplement existing fx reserves), reserve positions in IMF o no limits for fx rate fluctuations (it is based on supply-demand only) o central banks have no obligation to intervene to keep the currency fixed to some parity, but they should intervene to stabilize fx rates o country may choose a regime for its currency, but the expession in gold is prohibited o IMF supervises national monetary policies; countries must avoid any manipulations with fx rates to build some previliges toward other countries

country may choose from fixed, floating or managed floating regimes

The "Revived Bretton Woods system" identified in 2003 From 2003, economists such as Michael P. Dooley, Peter M. Garber, and David Folkerts-Landau began writing papers[10] describing the spontaneous emergence of a new international system involving an interdependency between states with generally high savings in Asia lending and exporting to western states with generally high spending. The developing world as a whole stopped running current account deficits in 1999 [11] - widely seen as a response to unsympathetic treatment following the 1997 Asian Financial Crisis. The most striking example of east-west interdependency is the relationship between China and America, which Niall Ferguson calls Chimerica. From 2004, Dooley et al began using the term Bretton Woods II to describe this state of affairs, and continue to do so as late as 2009.[12] However since at least 2007 those authors have also used the term to call for key international financial institutions like the IMF and World Bank to be revamped to meet the demands of the current age, [13] and from 2008 the terms Bretton Woods II and New Bretton Woods have increasingly been used in the later sense. Calls for the new Bretton Wood Leading financial journalist Martin Wolf has reported that all financial crises since 1971 have been preceded by large capital inflows into affected regions. While ever since the seventies there have been numerous calls from the radical left for a revamped international system to tackle the problem of unfettered capital flows, it wasn't until late 2008 that this idea began to receive substantial support from leading politicians. On September 26, 2008, French President Nicolas Sarkozy, then also the President of the European Union, said, "We must rethink the financial system from scratch, as at Bretton Woods." [14] However, Brown's approach is quite different to the original Bretton Woods system, emphasising the continuation of globalization and free trade as opposed to a return to fixed exchange rates[16] . There have been tensions between Brown and Sarkozy, who argues that the "Anglo-Saxon" model of unrestrained markets has failed.[17] However European leaders were united in calling for a "Bretton Woods II" summit to redesign the world's financial architecture. [18] President Bush was agreeable to the calls, and the resulting meeting was the 2008 G-20 Washington summit The meeting saw India's Prime Minister Manmohan Singh caution against protectionist policies and advocate a coordinated global fiscal stimulus to mitigate the severity and the duration of the current economic crisis.[19]. International agreement was achieved for the common adoption of Keynesian fiscal stimulus [20] , yet there was no substantial progress towards reforming the international financial system, and nor was there at the 2009 meeting of the World Economic Forum at Davos [21] Despite this lack of results Leaders have continued to campaign for Bretton Woods II. Italian Economics Minister Giulio Tremonti has said that Italy will use its 2009 G7 chairmanship to push for a "New Bretton Woods." He has been critical of the U.S.'s response to the global financial crisis of 2008, and has suggested that the dollar may be superseded as the base currency of the Bretton Woods system. [22] [23] [24] Choike, a portal organisation representing southern hemisphere NGOs, has called for the establishment of "international permanent and binding mechanisms of control over capital flows" and as of March 2009 has achieved over 550 signatories from civil society organisations. [25] March 2009 saw Gordon Brown continuing to advocate for reform and the granting of extended powers to international financial institutions like the IMF at the April G20 summit in London [26] and is said to have president Obama's support [27]. Also during March 2009, in a speech entitled Reform the International Monetary System, Zhou Xiaochuan, the governor of the People's Bank of China came out in favour of Keynes's idea of a centrally managed global reserve currency. Dr Zhou argued that it was unfortunate that part of the reason for the Bretton Woods system breaking down was the failure to adopt Keynes's Bancor. Dr Zhou said that national currencies were unsuitable for use as global reserve currencies as a result of the Triffin dilemma - the difficulty faced by reserve currency issuers in trying to simultaneously achieve their domestic monetary policy goals and meet other countries' demand for reserve currency. Dr Zhou proposed a gradual move towards increased used of IMF Special Drawing Rights (SDRs) as a centrally managed global reserve currency [28] [29] Leaders meeting in April at the 2009 G-20 London summit agreed to allow $250 Billion of SDRs to be created by the IMF, to be distributed to all IMF members according to each countries voting rights. 2) Contemporary currency regimes The IMF today is composed of national currencies, artificial currencies (SDRs) and the Euro. IMF Exchange Rate Regime Classifications: Exchange Arrangements with No Separate Legal Tender (39): Currency of another country circulates as sole legal tender or member belongs to a monetary or currency union in which same legal tender is shared by members of the union Currency Board Arrangements (8): Monetary regime based on implicit national commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate Other Conventional Fixed Peg Arrangements (44): Country pegs its currency (formal or de facto) at a fixed rate to a major currency or a basket of currencies where exchange rate fluctuates within a

narrow margin or at most 1% around central rate Pegged Exchange Rates w/in Horizontal Bands (6): Value of the currency is maintained within margins of fluctuation around a formal or de facto fixed peg that are wider than 1% around central rate Crawling Peg (4): Currency is adjusted periodically in small amounts at a fixed, preannounced rate in response to changes in certain quantitative measures Exchange Rates w/in Crawling Peg (5): Currency is maintained within certain fluctuation margins around a central rate that is adjusted periodically Managed Floating w/ No Preannounced Path for Exchange Rate (33): Monetary authority influences the movements of the exchange rate through active intervention in foreign exchange markets without specifying a pre-announced path for the exchange rate Independent Floating (47): Exchange rate is market determined, with any foreign exchange intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than at establishing a level for it 3) Fixed and flexible exchange rate systems in macroeconomic policy and corporate competitiveness Fixed exchange rate may be fixed in relation to a one chosen currency (USD, dollar), SDR, basket of currencies (usually trade partners of some country), moving parity (there is a firm relationship to some base currency, but the correlation is not automatic, but is calculated by some formula). Fixed Versus Flexible Exchange Rates and why countries pursue certain exchange rate regimes; based on premise that all else equal, countries would prefer fixed exchange rates: Fixed rates provide stability in international prices for the conduct of trade Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive monetary and fiscal policies Fixed exchange rates regimes necessitate that central banks maintain large quantities of international reserves for use in occasional defense of fixed rate Fixed rates, once in place, may be maintained at rates that are inconsistent with economic fundamentals The floating systems are in USA, EU, UK, Japan and other countries. But the central banks of these countries intervene and correct the fx rates if there are some large fluctuation, that is why we often speak about managed floating rate system instead of free floating rate systems. Attributes of the Ideal currency: Exchange rate stability the value of the currency would be fixed in relationship to other currencies so traders and investors could be relatively certain of the foreign exchange value of each currency in the present and near future Full financial integration complete freedom of monetary flows would be allowed, so traders and investors could willingly and easily move funds from one country to another in response to perceived economic opportunities or risk Monetary independence domestic monetary and interest rate policies would be set by each individual country to pursue desired national economic policies, especially as they might relate to limiting inflation, combating recessions and fostering prosperity and full employment

A country is limited to only two-sides per system. For example, if a nation wishes to pursue Monetary Independenceand Full Financial Integration, it cannot simultaneously attain Exchange Rate Stability. This is referred to as The Impossible Trinity, because a country must give up one of the three goals described by the sides of the triangle, monetary independence, exchange rate stability, or full financial integration. The forces of economics do not allow the simultaneous achievement of all three.

4) Choosing currency regimes in transition countries Currency Boards exist when a countrys central bank commits to back its monetary base, money supply, entirely with foreign reserves at all times This means that a unit of the domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first o Example is Argentina in 1991 when it fixed the Argentinean Peso to the US Dollar Dollarization the use of the US dollar as the official currency of the country Arguments for dollarization include: Country removes possibility of currency volatility Theoretically eliminate possibility of future currency crises Greater economic integration with the US and other dollar based markets Arguments against dollarization include: Loss of sovereignty over monetary policy Loss of power of seignorage, the ability to profit from its ability to print its own money The central bank of the country no longer can serve as lender of last resort o Examples include Panama circa 1907 and Ecuador circa 2000

5) Project of European Monetary Union A monetary union is a situation where several countries have agreed to share a single currency amongst themselves. The European Economic and Monetary Union (EMU) consists of 3 stages coordinating economic policy and culminating with the adoption of the euro. 16 member states of the European Union have entered the third stage and have adopted the euro as their currency. The United Kingdom, Denmark and Sweden have not accepted the third stage and the three EU members still use their own currency today. The Copenhagen criteria contain the requirements that need to be fulfilled and the time framework within which this must be done in order for a country to join the monetary union. Prior to adopting the euro, a member state has to have its currency in the European Exchange Rate Mechanism (ERM II) for two years. Denmark, Estonia, Latvia, and Lithuania are the current participants in the exchange rate mechanism. In order to participate in the currency, member states are meant to meet strict criteria: budget deficit of less than three per cent of their GDP, a debt ratio of less than sixty per cent of GDP, low inflation, and interest rates close to the EU average. ERM The ERM is based on the concept of fixed currency exchange rate margins, but with exchange rates variable within those margins. This is also known as a semi-pegged system. Before the introduction of the euro, exchange rates were based on the ECU, the European unit of account, whose value was determined as a weighted average of the participating currencies. ERM II replaced the original ERM. The Greek and Danish currencies were part of the new mechanism, but when Greece joined the euro in 2001, the Danish krone was left at that time as the only participant member. A currency in ERM II is allowed to float within a range of 15% with respect to a central rate against the euro. A first attempt to create an economic and monetary union between the members of the European Communities goes back to an initiative by the European Commission in 1969, which set out the need for "greater co-ordination of economic policies and monetary cooperation" (Barre Report), which was followed by the decision of the Heads of State or Government at their summit meeting in The Hague in 1969 to draw up a plan by stages with a view to creating an economic and monetary union by the end of the 1970s.

On the basis of various previous proposals, an expert group chaired by Luxembourgs Prime Minister and Finance Minister, Pierre Werner, presented in October 1970 the first commonly agreed blueprint to create an economic and monetary union in three stages (Werner plan). The project experienced serious setbacks from the crises arising from the non-convertibility of the US dollar into gold in August 1971 (i.e. the collapse of the Bretton Woods System) and from rising oil prices in 1972. An attempt to limit the fluctations of European currencies, using a snake in the tunnel, failed. The debate on EMU was fully re-launched at the Hanover Summit in June 1988, when an ad hoc committee (Delors Committee) of the central bank governors of the twelve member states, chaired by the President of the European Commission, Jacques Delors, was asked to propose a new timetable with clear, practical and realistic steps for creating an economic and monetary union[1]. This way of working was derived from the Spaak method. The Delors report of 1989 set out a plan to introduce the EMU in three stages and it included the creation of institutions like the European System of Central Banks (ESCB), which would become responsible for formulating and implementing monetary policy. The three stages for the implementation of the EMU were the following: Stage One: 1 July 1990 to 31 December 1993 On 1 July 1990, exchange controls were abolished, thus capital movements were completely liberalised in the European Economic Community. The Treaty of Maastricht in 1992 establishes the completion of the EMU as a formal objective and sets a number of economic convergence criteria, concerning the inflation rate, public finances, interest rates and exchange rate stability. The treaty enters into force on the 1 November 1993. Stage Two: 1 January 1994 to 31 December 1998 The European Monetary Institute is established as the forerunner of the European Central Bank, with the task of strengthening monetary cooperation between the member states and their national banks, as well as supervising ECU banknotes. On 16 December 1995, details such as the name of the new currency (the euro) as well as the duration of the transition periods are decided. On 16-17 June 1997, the European Council decides at Amsterdam to adopt the Stability and Growth Pact, designed to ensure budgetary discipline after creation of the euro, and a new exchange rate mechanism (ERM II) is set up to provide stability above the euro and the national currencies of countries that haven't yet entered the eurozone. On 3 May 1998, at the European Council in Brussels, the 11 initial countries that will participate in the third stage from 1 January 1999 are selected. On 1 June 1998, the European Central Bank (ECB) is created, and in 31 December 1998, the conversion rates between the 11 participating national currencies and the euro are established. Stage Three: 1 January 1999 and continuing From the start of 1999, the euro is now a real currency, and a single monetary policy is introduced under the authority of the ECB. A three-year transition period begins before the introduction of actual euro notes and coins, but legally the national currencies have already ceased to exist. On 1 January 2001, Greece joins the third stage of the EMU. The euro notes and coins are introduced in January 2002. On 1 January 2007, Slovenia joins the third stage of the EMU. On 1 January 2008, Cyprus and Malta join the third stage of the EMU. On 1 January 2009, Slovakia joins the third stage of the EMU.
Benefits of a single currency: A. Transaction costs and risks: 1) The most obvious benefit of adopting a single currency is to remove the cost of exchanging currency, theoretically allowing businesses and individuals to consummate previously unprofitable trades. For consumers, banks in the Eurozone must charge the same for intra-member cross-border transactions as purely domestic transactions for electronic payments (e.g. credit cards, debit cards and cash machine withdrawals). 2) The absence of distinct currencies also removes exchange rate risks. The risk of unanticipated exchange rate movement has always added an additional risk or uncertainty for companies or individuals that invest or trade outside their own currency zones. Companies that hedge against this risk will no longer need to shoulder this additional cost. This is particularly important for countries whose currencies had traditionally fluctuated a great deal, particularly the Mediterranean nations. 3) Financial markets on the continent are expected to be far more liquid and flexible than they were in the past. The reduction in cross-border transaction costs will allow larger banking firms to provide a wider array of banking services that can compete across and beyond the Eurozone. B. Price parity: Another effect of the common European currency is that differences in pricesin particular in price levelsshould decrease because of the 'law of one price'. Differences in prices can trigger arbitrage, i.e. speculative trade in a commodity across borders purely to exploit the price differential. Therefore, prices on

commonly traded goods are likely to converge, causing inflation in some regions and deflation in others during the transition. Some evidence of this has been observed in specific markets. C. Macroeconomic stability: 1) Low levels of inflation are the hallmark of stable and modern economies. Because a high level of inflation acts as a tax and theoretically discourages investment, it is generally viewed as undesirable. In spite of the downside, many countries have been unable or unwilling to deal with serious inflationary pressures. Some countries have successfully contained them by establishing largely independent central banks. One such bank was the Bundesbank in Germany; as the European Central Bank is modelled on the Bundesbank, it is independent of the pressures of national governments and has a mandate to keep inflationary pressures low. Member countries that join the bank commit to lower inflation, hoping to enjoy the macroeconomic stability associated with low levels of expected inflation.The ECB (unlike the Federal Reserve in the United States of America) does not have a second objective to sustain growth and employment. 2) Many national and corporate bonds denominated in euro are significantly more liquid and have lower interest rates than was historically the case when denominated in legacy currencies.[ citation needed] While increased liquidity may lower the nominal interest rate on the bond, denominating the bond in a currency with low levels of inflation arguably plays a much larger role. A credible commitment to low levels of inflation and a stable debt reduces the risk that the value of the debt will be eroded by higher levels of inflation or default in the future, allowing debt to be issued at a lower nominal interest rate.